IRS Stepping Up IRA Enforcement

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Have you ever had a client audited by the IRS for compliance with the minimum required distribution rules? Most practitioners report that such audits are rare to nonexistent, but that may be about to change. The IRS has identified, and is determined to end, growing noncompliance with the minimum distribution rules. Your clients can improve their chances of avoiding a time-consuming audit by taking their required distributions as early as possible.

Question: Do you have a recommendation regarding whether an individual who turns age 70 1/2 in 2010 should take the year-2010 minimum distribution for his IRA in calendar 2010, or postpone it until April 1, 2011? Is there any reason a client should take a required distribution earlier in the year rather than later?

Natalie: In March 2010, the Treasury prepared an internal "Audit Report." The report concluded that there is "growing noncompliance" with the minimum distribution rules (and also with the rules for IRA contributions--but that's a subject for another day). Extrapolating from a statistical sample, the report concluded that there were over 250,000 individuals who failed to take their minimum required distributions during the tax years 2006-2007. The auditor and the IRS management who reviewed the report agreed that a "service-wide strategy" is needed to address retirement plan noncompliance. So they are going to do something about this--but what? And how can our clients steer clear of IRS audits on this subject?

Here's the IRS's problem. Right now the IRS has only one way (short of individually auditing every taxpayer over age 70 1/2) to check whether individuals are taking their IRA required distributions, and that is to match "Form 5498" with "Form 1099-R." Every IRA provider must file with the IRS, each year, a Form 5498 for each IRA that provider administers. Form 5498 tells the IRS the name, address, and Social Security number of the IRA owner; the balance in the account; and whether a minimum distribution is required for the year in question. In any year when the IRA actually makes a distribution, the IRA provider must also file Form 1099-R with the IRS, reporting how much was distributed.

The only way, short of an individual audit, that the IRS can figure out whether an IRA owner is taking his required distributions is by seeing whether a 1099-R was filed with respect to each individual who had the "distribution required" box checked on his Form 5498. But this method of checking minimum distribution compliance is pretty crude. It does NOT tell the IRS whether the individual took his full required distribution--it just alerts the IRS to whether the individual took ANY distribution.

Another problem with this method is that it turns up too many false positives. For the tax years 2006-2007, the computer matching program found many thousands of people for whom Form 5498 was filed with the "distribution required" box checked and no Form 1099-R filed. There were so many of these people that the IRS could not audit all of them individually. So the IRS audited two subsets of these apparent minimum distribution non-takers: The IRS audited every member of the group whose IRA exceeded $1 million, plus a random sample of the rest.

In the random sample audit, the IRS analyzed a "statistically valid sample" of 96 individuals for whom a Form 5498 had been filed indicating that a distribution was required for 2006 or 2007, but for whom no Form 1099-R was filed for the applicable year. So had the IRS "caught" 96 wrong doers who owed penalties for failure to take their required distribution? Not at all. Here's what the IRS found:

* Twenty-eight of the individuals (29%) had actually complied fully with the minimum distribution rules. These were people who either turned age 70 1/2 during the year in question (but legally postponed their age-70 1/2-year required distribution until the following year), or who died during the year (and the minimum required distribution was timely taken by the deceased participant's surviving spouse as beneficiary).

* Twelve of the individuals (12%!) were victims of erroneous reporting by the IRA provider. Either they HAD taken the required distribution (but the IRA provider failed to file Form 1099-R) or they were not REQUIRED to take one (but the IRA provider erroneously checked the "distribution required" box on Form 5498).

* Fifteen of the individuals (16%) had died during the applicable year. Since the name and Social Security number of the beneficiary are not reported on Form 5498 for the year of the participant's death, the IRS had no way to know who the beneficiary of the account was, and so could not determine whether the beneficiary had taken the required distribution.

* That leaves just 41 individuals (43% of the group) who were found to have failed to take their required distributions and accordingly owed the 50% penalty.

The IRS performed a separate audit search on 111 individuals whose IRAs exceeded $1 million in value "who did not appear to have taken their" required distributions. This analysis turned up 88 people who had indeed failed to take their required distributions-but all 88 appeared to qualify for a penalty waiver, because their failure to take distributions was caused by illness, major life event, or other reasonable cause. At the time of the report, the IRS was "still working" on the cases of the other 23 members of this big-fish group.From this report, we can conclude the following:

* The IRS is bound to start forcing IRA providers to report the actual AMOUNT of the distribution required for each IRA on Form 5498, not just that a distribution is required. Assuming the IRA providers can improve on their 12 percent error rate, this would be a big advance in helping the IRS identify people who don't take their required distributions.

* The IRS will also presumably require IRA providers, on Form 5498, to provide the name, address, and Social Security number of the beneficiary(ies) of an IRA owner who dies during a year that a distribution is required, if the required distribution was not taken prior to death. Otherwise these year-of-death minimum required distributions will continue to disappear into a black hole as far as the IRS's computers are concerned.

* A client who wants to minimize the chances of IRS audit will take his age 70 1/2-year minimum required distribution in the age 70 1/2-year. He can legally postpone it until as late as April 1 of the age 71 1/2-year, but doing so will create a mismatch in the IRS computer. The IRS will received a Form 5498 for the age 70 1/2-year showing "distribution required," but no Form 1099-R showing that a distribution was taken. So perhaps the client should not postpone that required distribution to the following year unless there is a really strong reason to do so (for example, the individual expects to be in a lower tax bracket the following year).

* A client who wants to reduce the chances of the IRS's auditing his survivors will always take his IRA required distributions early in the year. If he postpones until late in the year, then dies prior to taking the distribution, the Form 5498 filed for his IRA for the year of his death will show "distribution required" but no Form 1099-R will be filed for him because he didn't take the distribution. Even if the beneficiary duly takes the year-of-death required distribution before the end of the year, there will be a mismatch in the IRS computer that may trigger an audit.

On the scale of life happiness, the best is to do your minimum required distributions right and not get audited. Doing things right and getting audited is definitely second best.